Logic and discipline can mitigate the risk of investment

PF University Investment and risk go cap in hand, so before we start looking at how to invest, I want to make some important observations on the nature of risk.

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Investment and risk go cap in hand, so before we start looking at how to invest, I want to make some important observations on the nature of risk. Risk is the possibility that your investment will lose some, or even all, of its value. A safe investment has a relatively predictable outcome; a risky investment does not. Cash on deposit is safe and you know what rate of interest to expect; investing in a prospecting gold-mining company is very risky, making the outcome far from certain.

So how do we go about assessing risk for our hard-earned money? Financial risk is the most obvious, since you can lose your cash if the company whose shares you buy loses money or goes belly up. You must therefore conduct an adequate amount of research and choose your shares carefully. Remember the dot.com boom: high debt, little (no) earnings and plenty of competition? Profit is the lifeblood of every company.

Interest-rate risk is another vital consideration, so keep an eye out for both expected and sudden changes and act accordingly. Millions of investors buy and sell shares every minute, which affects share prices, in turn creating market risk. It is nearly impossible to predict which way your shares will move tomorrow or next week, so I constantly advise people to invest - except in certain circumstances, such as investing for the down payment on a house - for the long term only. Anything less will amount to speculation.

Other risks may stem from inflation, and this is most relevant to money on deposit: if your bank pays you three per cent for your cash deposit and inflation is running at 4 per cent, you are losing money. Finally, there is emotional risk, most often caused fear and greed. Logic and discipline are critical factors for successful investing, so don't get carried away by greed. When the taxi driver offers you a hot stock tip, be very careful. Likewise, don't be afraid to invest, because you might end up unnecessarily settling for a low rate of return on your cash. All of these warning stated, it is important to know that you can mitigate these risks with intelligence and diligence and by becoming better informed.

Since a high-risk investment is likely to produce an outcome that deviates dramatically from the normal expected return, you can use a measure known as standard deviation to help assess risk. In an extreme example, a share might produce an annual return on your investment of 10 per cent, but the actual share price will fluctuate wildly during this 12-month period. So, if you buy your share in January at 100, it could fall to 50, jump to 150 in July and close out the year at 110 - hence the 10 per cent annual return - representing a standard deviation of 50 per cent, which may be high for your risk profile.

Since we want to minimise risk and maximise the investment return, we need to be able to judge whether the risk is high or low. "Sharpe Ratio" may be a new term to you, but it is an important tool. Essentially, it shows the return on an asset against how much risk is required to achieve that return. The ratio is calculated by dividing the return by the standard deviation, so the higher the ratio, the higher the return relative to the risks involved. Use these measures on a few stocks you own, or are considering adding to your portfolio to get the hang of risk assessment.

Diversification is a very important strategy as well, because this allows you to spread your money across different investments. After all, we know that it's unwise to keep all of your eggs in one basket (You may want to google Harry Markowitz, a Nobel Prize laureate who showed us how to diversify in order to produce the optimum return with the least risk). John McGaw is a financial adviser based in Dubai. Contact him at jmcgaw@emirates.net.ae